How to Sequence Your “Get Ahead” Dollars

It led to a YNAB office chat about how to sequence your “get ahead” dollars – a “get ahead” dollar being defined as one that either reduces the balance of a loan or recruits other dollars (ie investments).

Here’s what we came up with:

*The usual disclaimer: no part of this article is meant as investing advice. I present this information only for discussion purposes.

The only possible exception is when your employer-matched 401k contributions give you an instant 100% ROI on those dollars. I say possible exception because it’s hard to be wrong when you make it your top priority to get rid of high interest debt.

A key distinction here would be that you’re only contributing the amount necessary to receive your full employer match. Once you’re getting all the free dollars you can from the match, put your extra dollars into a Roth IRA (I’ll explain momentarily).

3. or 4. Pay off lower-interest debt.

This would include anything in the 0% to 6% range. My mortgage is at 3.99% interest. Does it make sense to prioritize it ahead of maxing out my tax-advantaged retirement accounts?

The strict math says I’ll likely earn more than 3.99% in the market than I would in an indexed mutual fund protected by a Roth IRA. On the other hand, paying off my home allows me to have a much smaller retirement nest egg.

I personally lean toward paying off my house. We’ll see if that’s still true when I’m finished with my higher-interest debts.

4. or 3. Max out Roth IRAs for yourself and your spouse.

The 401k was originally created to supply up to 20% of your pre-retirement income, but quite a few people seem to think it’s the only retirement vehicle they need.

Not only is a 401k not likely to get you through retirement on its own, a Roth IRA has features that make it more appealing than most 401k plans:

a. After you reach the qualifying age, withdrawals from a Roth IRA are tax-free.

b. You’re likely to have more control over the funds inside your Roth IRA than you would with your company-sponsored 401k. For example, Jesse had to pay an extra fee to allow YNAB team members access to Vanguard mutual funds. I don’t think many employers would do the same, which means you may not be able to access top-performing funds unless you seek them out in your own Roth IRA.

c. There’s less hassle and overhead associated with a Roth IRA in the event you change jobs or companies.

5. or 6. Max out traditional IRAs for yourself and your spouse.

Traditional IRAs give you an up-front bonus on your saved dollars because you make contributions with pre-tax income. In other words, you don’t pay taxes on the money you put into a traditional IRA.

You will, however, pay taxes on the withdrawals you make after reaching a qualifying age. That’s why – other things being equal – we prefer Roth IRAs. They offer the same investment opportunity (currently capped at $6,000 per year, per person) while also offering tax-free retirement income.

6. or 5. Max out Health Savings Accounts for you and your spouse.

Health Savings Accounts are the only financial/investing instrument that allows you to make pre-tax contributions and withdraw the money tax free.

You can also use the money as-needed to cover qualifying medical expenses. In other words, HSAs are great tools.

7. Having maxed out all your tax-advantaged savings vehicles, save any extra money in taxable investments.

How’d we do? Do you sequence your “get ahead” dollars differently?

For a more detailed discussion of saving and investing, check out Jesse’s (YNAB founder) 9 Day Investing Course.

In practice, I’ve been planning for it to go after “Pay off high-interest debt”, since it seems too expensive not to, plus in Jesse’s interview, MMM recommended “treat[ing] debt as if you were on fire and covered in bees”. But I always wonder…

Unless you know that you’re a particularly irresponsible credit user, I would always recommend paying down high-interest revolving loans (i.e. credit cards) before starting an emergency fund. The reasoning is simple. If you have an emergency, you can just run up your credit card again, and you’ll be no worse off than if you hadn’t paid off the card in the first place. If you don’t have an emergency, then you’ll have successfully paid off your card!

For those of us totally new to the world of retirement savings, can you explain why Roth IRAs are more attractive than traditional IRAs? Is it always better to pay taxes before putting money in the account rather than when taking it out? I imagine there could be more compound interest if more money goes in initially, and what can you expect your tax rate to be when you retire?

Roth accounts have a number of special advantages that aren’t available to traditional account. For example:

– You can withdraw your contributions at any time
– After 5 years, you are eligible for qualified withdrawals, such as the first home exemption
– There are no required minimum distributions — so you don’t have to withdraw the money until you need it

Note that I wouldn’t generally recommend that people withdraw from their Roth willy-nilly, but given the choice between depositing money into your Roth and withdrawing some of it later, or never depositing money in the first place, it’s clear that the former is the better option.

Also, if you’re maxing out your retirement account, then the Roth effectively has a higher maximum than the traditional account, since the Roth’s maximum is post-tax, while the traditional’s maximum is pre-tax.

Finally, people of any income level can contribute to a Roth (either directly or through the “back door”), while contributions to a traditional IRA stop being tax-deductible at a relatively low income level. That is to say, the people who are paying high marginal tax rates don’t really have the ability to contribute to a traditional IRA, while the people who are eligible are generally paying such a low rate of tax that they might as well lock it in.

As far as the compound interest goes, mathematically, it works out exactly the same. Either you pay the taxes on a small amount now, or you pay the same amount of tax on the larger amount later.

another detail (I didn’t see mentioned) that would elevate the Roth over the Traditional: Tax-deferred vs Tax-free. A traditional IRA grows tax deferred. You put in pre-tax dollars and do not pay taxes until you “realize” the growth, by way of distribution (taking the money home).

Roths grow TAX-FREE. You fund a Roth with after-tax dollars. The growth in that account is not taxed when you take it home (you have already paid the taxes). This has at least on significant advantage: the “seed” money, or your basis, is smaller than the potential growth (thus you pay lower taxes).

My employer offers both Traditional (before-tax) and Roth (after-tax) 401k options. Since (AFAICT) Roth 401k and Roth IRA have the same tax advantages, I never really looked much beyond what they offered. Their selection of funds is also very good. I guess I always assumed that most employers that offered the Traditional 401k would offer the Roth option too. Am I really in a unique situation?

I see the arguments about fees and access to funds when you change jobs, etc., though, when comparing 401ks to IRAs.

Many employers offer Roth 401(k) plans, but they’re definitely not as widespread as traditional plans.

Compared to the situation with IRAs, Roth 401(k)s offer fewer advantages. Roth 401(k)s still have required minimum distributions. You aren’t allowed to withdraw your contributions at any time. There are no income thresholds that limit your ability to deduct contributions to a traditional 401(k). Therefore, the question is much simpler. Do you think that your marginal tax rate will be lower now, or in retirement? And/or, do you think that the ability to shelter slightly more money in the Roth (since the contribution limit is post-tax) makes up for the higher tax rate that you’ll pay now?

If you’re very early in your career, or if you’re planning on moving to a higher-tax jurisdiction when you retire, then the Roth can make a lot of sense. But for most people, the traditional is probably the best bet.

Ignoring the tax advantages of deferring more income in the 401k is a huge oversight. Most people can really benefit from reducing their taxable income right now and investing the difference. This is oversimplifying it.

All else equal, a Roth option beats a traditional option (whether we’re talking about a 401k, or an IRA), at least in my opinion. Here’s my thinking:

1) “You mention that most people can really benefit from reducing their taxable income right now”, but we really don’t know if they’re benefiting or not, because we don’t know what their tax rate will be once they begin withdrawing money from that tax-deferred vehicle. Since we cannot (at all) predict what future tax rates will be, we can’t reasonably rely on that as an advantage or disadvantage for either vehicle.

2) The math works out to be the exact same IF, tax rates are equal when investing the funds, and then when withdrawing the funds. In other words, a person taxed at 25%, that has an after-tax $4000 to invest in a traditional IRA would make the investment, see it grow tax-free, and then withdraw the nest egg at a later date and pay 25%.

The Roth Investor would pay taxes on the $4000, leaving only $3,000 to invest. The $3,000 would grow tax-free, and then upon withdrawal, would not be taxed. If you plug this all into a spreadsheet, you realize that their withdrawal amount is the exact same.

(In this example, one questions our fictional investor’s ability to actually invest a higher amount in their traditional IRA because of the implicit tax savings…my gut tells me people simply invest what they can, which leads to point #3.)

3) Since people likely simply invest just what they can, with their behavior not changing based on tax savings from the deferral of income into a traditional IRA (or 401k), the LIMITS on both of the vehicles becomes important.

Both a traditional IRA and Roth IRA are capped at $6,000 this year. Assuming our investors have $6,000 to invest, and can max out either option:

Since the Roth IRA investor will not be taxed again on their funds, they’ve technically been allowed to invest MORE because it’s after-tax dollars. If they were in a 25% tax bracket, they invested an equivalent of $8,000 ($6,000 / (1-25%)).

4) The Roth, because it’s tax-free, doesn’t require mandatory withdrawals after you turn…70 1/2 years old I believe. The ability to time your withdrawals, and turn on/off the spigot of income, as it relates to your taxes in retirement, is a huge asset in planning. Both the 401k and traditional IRA have mandatory distributions that must be taken, forcing you to perhaps recognize income in an unusually high year, and pay a suboptimal amount of taxes.

While Mark’s prescription was simple (do this, then that), I think it was still accurate.

Speaking as one who is retired (self-unemployed as my kids put it) and living entirely off of IRAs, here are some considerations that are not obvious.

Traditional IRA money is treated as ordinary income. When you withdraw traditional IRA money you will be forced to withdraw more than you would need if it was Roth IRA funds. That’s because you need enough traditional IRA income to pay income taxes. If you are taking minimum required distributions you will take much more in distributions than if you were taking Roth money.

Now think of things like the new subsidized Obamacare insurance. Because of the much higher income taken out on a traditional IRA you will be less likely to qualify for an insurance subsidy. Social Security is also income based. If you make too much (as you are more likely to do with when withdrawing traditional IRA funds) you get less in Social Security payments. If you have kids trying to qualify for school loans, again you will show much lower income if you are living off of Roth funds. Believe me, if you can live the same whether on high traditional IRA income or on low Roth IRA income, you will always be better off showing the lower taxable income. So why would anyone invest in traditional IRAs? One reason, my reason, is that for many of us there was no such thing as a Roth when we were working.

1. We can’t predict tax rates, but for the average household, we can safely predict that their income in retirement will be lower than their income is now. Consider a household that earns $60,000/year. They spend 25% of their income on housing (most of which is a mortgage payment), and they also save 20% of their income for retirement. These two expenses completely disappear during retirement. So right away, this household only needs to withdraw $33,000/year in retirement. Clearly, they’re going to be paying less tax in retirement than they’re paying now!

2. I agree with your math, but it is important to consider the progressivity of the tax code. The first few dollars that you withdraw from a traditional account will be taxed at a very low level. In fact, due to the standard deduction and personal exemption, a married couple can withdraw almost $20,000/year from a traditional account (assuming that it’s their only taxable income) without paying any tax at all! If you put all your money into Roth accounts, you’re unnecessarily paying your current marginal tax rate.

3. This is certainly true. But many people aren’t maxing out their accounts, in which case this doesn’t really apply. And even if you are maxing everything out, it’s still important to keep in mind the points I raised in #1 and #2. If you work out the math, it’s still possible that you’ll come out ahead with some mix of traditional and Roth contributions, so as to take advantage of the low-tax space at the bottom of the tax bracket.

4. This is true for Roth IRAs. It’s not true for Roth 401(k)s, which have required minimum distributions just like traditional 401(k)s.

The higher your after-tax salary is, the greater your social security will be. So, using a ROTH can help your bottom line in that way – assuming SS will be there.

On the other hand, sometimes having a higher salary cuts you out of financial help. Due to a salary increase, my kids are not eligible for a scholarship for camp. So, instead of a free camp, they will owe over $550 each. I can’t afford that. So, is it better to take out a traditional IRA to reduce the income level, and get the free camp, plus get more tax money back? Plus, some kids going to college have the same predicament. If their parents make too much, they get cut out of scholarships. That’s an instant loss.

I’ve always done the ROTH when I could do anything. And, in previous years, we actually converted and took a huge hit on our taxes just so we would be free of taxes when and if our investments increased. The timing was horrible because we just got a better job. We should have done it when we were jobless – but we couldn’t afford to pay the taxes! Catch 22.

I guess the part that I am still struggling with is the fact that when i put the 6000 post tax into a ROTH I am doing that at a higher cost because I paid the taxes now which means i have less money to work with in my daily budget need. The PreTax vehicle allows me to put more away now $17.5K So the key is more money pre-tax now compounds faster then less post tax money… you pay TAX either way but 6K a year at 8% vs 17.5K at 8% is a big difference in 30 years, and I can get to that 17.5K faster because I have more Gross Income to throw at it? Or am I missing something?

If your highest interest debts are one or more credit cards and if you are maxed out on those accounts, then pay them off last. I know this flies in the face of logic but I have found that if a person is maxed out on his credit cards, then paying them down only frees him up to use them again. If you start paying off other debt first, your credit accounts are not available to you because they are maxed out. Hopefully, after not using credit cards for awhile, meanwhile getting into the no-debt mentality you will reach a point where you no longer are tempted to use them and can then begin to pay them off.

I understand where you’re going with this. I think a better approach, for people who recognize that they can’t control their spending, is just to cut up the cards and close the account. If you need to, close every single one of your credit cards. Closing the account won’t force you to pay it off immediately — it will just turn into an installment loan. The potential hit to your credit score is less important than the hit to your finances if you continue to pay interest unnecessarily.

Agreed! I was one of those that worked hard to pay down the credit card balances, only to load them back up over time! Some of us have a history of accumulating debt over and over again on high interest credit cards, or bouncing balances from one card to another. If you’re like I was and continue to repeat this stressful cycle, I suggest getting out of denial and getting out the scissors! The relief is tremendous!!

I didn’t have credit card debt, but I did have several student loans. And, sadly, the lowest interest rate was the smallest and the highest was the biggest loan. So, I, too, flew in the face of paying off the highest rate first. I felt that my dollars could not stretch far enough each month. So, I paid off the smallest loan first. That was a huge psychological boost, and it freed up that entire payment for me to apply to the next smallest loan and have a little wiggle room in case of a rainy day. In that way, I was able to pay off $28,000 in debt in only 3 years with a salary about $32,000. I really don’t think I could have done it that quick if I had not snowballed my payments. You can’t always do the high interest first.

What if you’re thinking about early retirement? Is maxing out a Roth and (if you can) the 401(k) (or traditional IRA) the best approach since those funds have limited access before 59 1/2? Would it be better to max out the Roth, get your employer’s match and then put whatever you can into a taxable account?

What about when “maxing out” anything isn’t an option (IRAs, 401ks, HSAs), and rather “getting by” is the norm (YNAB is helping, but it’s still slim), and you suddenly come upon $500?
This happened to us recently. It currently rests in a savings account, but we were thinking of putting half of it in an index fund. We don’t have any high-interest debt, though we do have low-interest debt (car loan, scooter loan, plenty of college loans). We are unsure of what to do with this money. Originally we planned on putting it towards one of the loans, though with what little savings we have that seems risky.
Any opinions?

My advice may not be popular to all (on this site) but it is the advice I followed and I can attest to its success:

Work the baby steps. Start with 1) $1000 baby emergency fund. (If you are at or below the poverty line, adjust this to $500. 2) Debt Snowball. Order your debts from smallest to largest. Make minimum payments on all but the little one. Scrape together all you can and attack the little one with a vengeance. Once you pay off the little one, move to the next (using the money that was going to the little one, plus the minimum payment that was already being paid to this one, plus anything else you can scrape together and continue the attack. Each time you pay off a debt, the snowball gathers more snow…

After baby step 2 is complete, move onto baby step 3. Baby step 3 is finish the emergency fund (which started in babystep 1, with $1000, and which you now will grow to 3-6 months of expenses). To give yourself a fighting chance, you should evaluate your expenses and eliminate non-essentials. Remember, the Emergency Fund is to cover Job loss, etc. You probably aren’t going to pay for cable and dining out, etc during a crisis).

Baby Step 4 is 15% of your income (gross pay) in to retirement. This is accomplished via multiple vehicles (401k, RothIRA, etc). First things first. Take advantage of any match at your work. This is basically the same as getting 100% return on your investment. In my case, my company has a 4% match, so the first 4% of my 15 is in my 401k at work. Then, the next vehicle is the Roth. Currently, based on income limits, you can fund a Roth for you and your spouse (up to 5,500 each -per year). For now, while in Baby Step 4, you will only do as much of the roth as it takes to get you to 15%. (If you fund the Roth to 5500 each and have not reached the 15% mark, then return to the 401k and put more in there.

Baby Step 5 is Kids College fund. If you have no kids, skip this.

Baby Step 6 is pay off the house early.

Baby step 7 is to save, give and spend like no one else.

I only mention this to give road map to finances. These guidelines, should you choose to follow them will answer what you should do with that windfall.

I can tell you, with absolute certainty, if you commit to follow the plan, you will succeed. Between you and freedom is a hill (it seems like a mountain now) but I, and others like me, are on the other side of it, saying it is possible. Freedom exists and it is WONDERFUL. You can do this!

I do not agree with saving for the Kids’ College Fund before paying off the house. The house is debt. It is accruing interest. The faster you pay it off, the more money you will have in the long run. You have a duty to yourself and your kids to be self-sufficient. Saving for a nebulous event in the future is not in keeping with the 4 rules, either. There are many things that can happen. A kid could not make it to college for various reasons. I have friends who died in high school, friends who had car accidents and took many years to make it there, friends who never went to college, and friends who got full rides to college. But, your mortgage is still there. Paying it off early (or better yet, never having one because you saved) will put you thousands and thousands ahead – essentially saving for college. If parents have less debt by the time kids go to college, they could put all that toward the schooling then. Or, they can take out loans, which have deferred interest rates, and pay them off as soon as they come due. That gives you several more years to save.

I am sorry for your loss(es). i, too, had deaths in high school. Regarding your counter, your house is one of the only things (if not the only thing for which you might take out a loan) that actually appreciates. While the 100% down plan is an EXCELLENT plan, most people are unwilling to delay pleasure that long. So, if we simply “must” have a house, and we have not saved to pay for it in cash, an 80% Loan-to-Value ratio (or less) on a 15-year fixed-rate mortgage, whose payment is not more than 25% of your net monthly income, is generally acceptable.

Now, while I agree that there are no guarantees, We still must try. We still must plan. If you do the steps prescribed, paying off the house early will happen. And forgive me if I made it seem like you could not do step 5 until you do step 4, or 6 until you do 5. What is seen most often is that once 1-3 are out of the way, 4-6 are often done simultaneously.

As for getting full rides, or choosing not to go to school, etc, there are means to address this as well. Saving for college is not throwing the money away (if circumstances dictate that your kids can’t use the money for school). That savings can be realized as income (though a penalty would probably be due). Keep in mind that the growth of that account will adequately offset (and then some) such penalties.

As for me, personally, I am not currently saving for my kids college. We were FOOLISH with money for much of our lives and only recently walked the steps (currently on #4). Having said that, my oldest 2 are 17. I have told them that their best options for college are CC to cover the first 2 years (at a significant savings), scholarships, enlisting in the Armed Forces, or a little known thing called W O R K. I also made it clear that we would not be participating in behavior/choices we (as their parents) did not approve of. Our poor financial management (buying stuff we could not afford with money we did not have -ie loans and CC) lead us to the point where we cannot pay for school, so we were not going to be signing for them to take out loans. We would, however, assist (with cash and room/boarding) were we could, when we could to help them afford school.

As someone who has walked this difficult road, I know (for a fact) that the plan works. Ultimately, however, you will believe what you choose to, or allow yourself to believe.

This is all very well but living over the pond in the UK, ‘IRA’ is something very different (http://en.wikipedia.org/wiki/Irish_Republican_Army)! I appreciate that the majority of YNAB’s customers are US-based and it’s of course impossible to cater for everyone (I have absolutely no idea about tax -efficient savings / investments in, say, Oz) but it does occasionally feel like it’s all aimed squarely at the US…where are those ISAs (http://en.wikipedia.org/wiki/Individual_Savings_Account)?! Or maybe every once in a while, it should be a more general discussion with US-tailored thoughts after the generalised thinking?